The United Arab Emirates (UAE) introduced the Economic Substance Regulations (ESR) in April 2019 to be excluded from the EU’s COCG grey list (European Union's Code of Conduct Group) and not to be classified as a harmful tax jurisdiction by the OECD/G20 Inclusive Framework on Base Erosion and Profit Shifting (BEPS).
Not long after its introduction, UAE launched a new (amended) ESR legislation in August 2020, which was based on the outcome of the review of the no or only nominal tax (NOON) jurisdictions, concluded in June 2019, by the OECD’s Forum on Harmful Tax Practices (FHTP). The new law is more aligned to the international standards stipulated in the BEPS Action 5 and is retroactively effective from 1 January 2019.
The new ESR law introduced exciting amendments, such as: granting exemptions to branches and permanent establishments of foreign entities from meeting the substance test, expanding the scope of the distribution and service centre business, extending its applicability to government entities having a global presence, etc. In addition to this, the new ESR legislation granted substantial powers to the Federal Tax Authority (FTA) to oversee compliance, perform assessments and impose administrative penalties on defaulters.
The Ministry of Finance (MoF) also built a dedicated portal for licensees to submit their ESR notifications and reports to encourage compliance. Through this portal, licensees remain up to date about their ESR obligations, receive enquiries and assessment and penalty notices from the Regulatory Authorities (RA) or the FTA through the same channel.
In response to the ESR submissions made by the licensees for FY 2019, the RA and FTA have been reasonably active in asking for explanations and documentary pieces of evidence to substantiate the exemption status or meeting the economic substance test. In certain cases, the Regulatory Authorities have requested licensees to provide their land lease agreements, minutes of board meetings, outsourcing agreements, and other documentary evidence to prove that it meets the economic substance test. In other cases, the request for information was vague and broad, leaving room for a lot of interpretation. It is also observed that the RA/FTA have not hesitated to levy penalties in cases where the licensees have failed to comply with the ESR obligations.
To resolve technical errors, the support team at the Ministry of Finance (MoF) has been responsive over emails and calls. Additionally, licensees are allowed to rectify/amend the submitted ESR notifications or reports without levying additional penalties (although the deadline may be very short, e.g., five (5) business days).
Despite the available guidance and technical support from the MoF, licensees faced several challenges in meeting the ESR requirements, e.g., identifying the ultimate parent entity and/or ultimate beneficial owners in limited liability partnership structures, calculating the income/expense related to the relevant activities in the absence of prescribed methods, classification of the relevant activities, meeting the branch exemption, etc. Licensees also struggled to meet the substance test that requires them to substantiate the fact that they carry out the relevant activity, i.e., they are directed and managed in the UAE, and they meet the "adequacy test", i.e., they have adequate expenditure, premises and employees to conduct their business operations in the UAE, either themselves or through an outsourcing service provider.
With several factors involved in doing business globally, Multinational Enterprises (MNE's) might fail to meet the substance test in the UAE. Failure in meeting the substance test results in an administrative penalty of AED 50,000 for the first offence and AED 400,000 for a subsequent one. Further, it may also result in other countries taking defensive measures such as denying deductions, imposing withholding taxes on payments to companies or applying controlled foreign corporation rules to subsidiaries in such jurisdictions.
The key takeaway from this discussion is:
- Licensees should evaluate whether they carry out a relevant activity in the UAE and be prepared to demonstrate that their core income-generating activities are in line with the income and profits reported in the UAE.
- Licensees that have failed to meet the ESR requirements for FY 2019 must take all necessary steps to ensure they comply with the ESR requirements for FY 2020 to avoid penalties, sanctions and other measures taken by the foreign tax jurisdictions.
- Licensees must retain all documentary pieces of evidence for claiming an exemption status or meeting the substance test.
- Licensees must be vigilant to provide documentary evidence/explanations to the enquiries they might receive from the RA/FTA during the ESR assessment.
- Successively, licensees must ensure they submit the notification within six months from the end of its financial year and if it is liable to submit an ESR report, it must submit it within twelve months from the end of its financial year.
The implementation of ESR by the UAE is subject to a peer review from January 2021 to ensure the standard is effectively implemented by UAE. As a result, UAE may amend its ESR legislation in the future again.
Round 1 of the ESR was underestimated by the businesses, but the RA/FTA took it seriously. Therefore, as a forewarning for round 2, businesses that carry out one or more relevant activity in the UAE must either consider increasing their substance if not adequate or consider alternative restructuring options, e.g., redomiciliation into another jurisdiction, restructuring, liquidation, etc., to dodge the substance requirements. Tax payers who fail to meet the substance test for a second consecutive year will be exposed to a penalty of AED 400,000, and, what is probably worse, the tax authority of the parent jurisdiction will be informed of the lack of substance in the UAE.
Our previously conducted webinar may help in filling out the notifications and forms. Additionally, consistency in meeting the different disclosure requirements is important, as Ultimate Beneficial Owner filings and the Country by Country reporting may require similar information to be disclosed and these disclosures allow reconciliation with the ESR information disclosed.
Round 2 starts with notifications by end of June 2021 for FY 2020. Tax payers have been warned.